After years of consideration, the Financial Accounting Standards Board (FASB) issued new accounting standards in February 2016 to improve financial reporting about leasing transactions, clearing the way for organizations to adopt new strategies pertaining to their real estate leases. The much-anticipated accounting changes introduce a multitude of scenarios to consider as lease contracts assume a more material role on corporate financial statements. Executives must take action in this new landscape to ensure that accounting consequences are consistent with corporate objectives. Mike McLain, Transwestern’s chief accounting officer, outlines several lease accounting changes and their potential impact on real estate occupiers.
UNDERSTANDING ‘FINANCE’ VERSUS ‘OPERATING’ TREATMENT FOR REAL ESTATE LEASES
Under the new regulations, occupiers will have to decide whether to structure their leases to obtain finance or operating lease accounting treatment. The best selection could be determined, in part, by the financial metrics important to the company, such as the method(s) utilized to value the firm. Real estate representatives and accounting specialists who have studied the options say the classification could lead to very different outcomes. Finance lease treatment recognizes expense amortized similarly to a mortgage, with interest and amortization components and a front-loaded expense pattern. Alternatively, operating lease treatment records expense straight-line, which has been the traditional approach. Both methods will require a significant amount of assets and liabilities to appear on the balance sheet that previously were not included.
COMPANIES DRIVEN BY EBITDA VALUATION SHOULD CONSIDER FINANCE LEASE TREATMENT
When financial performance is measured by EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), companies may have an opportunity to benefit by structuring real estate leases to achieve finance lease treatment. As a result, lease expenses would be excluded from EBITDA as they would be considered interest and amortization under the new standard. This concept could appeal to private companies – particularly ones experiencing high growth, such as tech firms. Take, for example, a company paying $1 million in annual rent whose EBITDA is $10 million and is valued at 10 times earnings; its worth would be $100 million. Under the new standard, the rent becomes an excluded expense under the finance lease treatment; therefore, the firm’s EBITDA increases to $11 million and its value rises to $110 million.
|FOR COMPANIES USING EBITDA EARNINGS MEASUREMENT|
|Company A pays $1M in annual rent||>||Uses Operating Lease Accounting Treatment that records $1M lease as an expense||>||Assuming EBITDA is $10M and value is 10 x EBITDA||>||Company A is valued at $100M|
|Company B pays $1M in annual rent||>||Uses Finance Lease Accounting Treatment that does not record $1M lease as an expense||>||Assuming EBITDA is $11M and value is 10 x EBITDA||>||Company B is valued at $110M|
NEW ACCOUNTING RULES COULD CAUSE BREACH OF LOAN COVENANTS
When a company adds leases to its balance sheet, the adjustment could impact its debt-to-equity ratio. Many lenders have debt-to-equity ratio requirements written into loan covenants and the shift could throw some firms out of compliance. Ideally, companies prefer that lease commitments not be considered inside a loan covenant. In anticipation of the upcoming change, companies are advised to ascertain how their lender intends to treat commercial real estate leases once the new guidelines go into effect. Will they be viewed as additional debt? Can the loan covenant be modified? If a bank includes lease obligations as debt, corporate occupiers may seek shorter lease terms to mitigate the balance sheet impact.
ADVICE DIFFERS FOR FIRMS WITH CAPITAL RESERVE REQUIREMENTS
Banking institutions and financial service firms have unique considerations due to regulations requiring them to maintain certain capital reserves in proportion to their liabilities. Imagine that based on capital requirements, for each risk-weighted asset on a financial services firm’s balance sheet, such as a lease, a company’s capital reserves must increase 5 percent. In this example, if a firm’s lease obligations total $100 million annually, its capital reserves would increase by 5 percent, or $5 million, to cover that liability. These types of organizations should consider operating lease treatment to minimize the liability associated with leases, and may want to consider executing shorter term leases to minimize impact on the balance sheet and capital reserve conditions.
|Potential Impact of FASB Standards on Financial Institutions|
|Financial Institution A||Financial Institution B|
|Signs 3-Year Lease||Signs 10-Year Lease|
|Terms include $1M annual rent x 3 years = $3M, which creates $3M liability on balance sheet upon lease commencement||Terms include $1M annual rent x 10 years = $10M, which creates $10M liability on balance sheet upon lease commencement|
|Firm is required to augment capital reserves with an additional 5% of total lease liability ($3M x 5% = $150,000)||Firm is required to augment capital reserves with an additional 5% of total lease liability ($10M x 5% = $500,000)|
|Financial Institution A has the preferred position. By signing a shorter-term lease, it retains control of more of its capital in comparison to Financial Institution B, resulting in an additional $350,000 available for company operations, etc.|
NEGOTIATING LEASE OPTIONS BECOMES MORE COMPLICATED
Accounting changes pertaining to lease extension options will require in-depth evaluation by all types of companies in collaboration with their advisors. In the tenant’s original lease language, if a building owner offers the occupier a bargain or discounted rate in connection with a possible lease extension at the end of the term, that “economic incentive” could impact how the lease is classified beginning on Day One. For example, consider a tenant signs a 10-year lease with two five-year renewal options that carry an incentive, such as the owner offering 95 percent of market rental rate during the extension period. While it is technically a 10-year lease, it could be viewed as a 20-year lease for accounting purposes if it is considered “reasonably certain” that the options will be exercised. A careful analysis will determine the most beneficial outcome in this new environment.
|Initial Lease Term||1st Renewal Option||2nd Renewal Option||Total Term on Day 1 if Lessee Does Not Have Significant Economic Incentive to Exercise Options||Total Term on Day 1 if Lessee Has Significant Economic Incentive to Exercise Options|
|10 Years||5 Years||5 Years||10 Years||20 Years|
IS IT BETTER TO OWN – RATHER THAN LEASE – REAL ESTATE?
In the years leading up to the FASB change, experts speculated whether the new guidelines would make it advantageous for occupiers to purchase rather that lease commercial space. Property ownership comes with many additional financial and operational considerations. It’s our contention that buying a building is an economic decision, not one based on accounting, so we do not expect a widespread acquisition movement.
MATRIX OF CHOICES AND OUTCOMES WILL CAUSE SCENARIOS TO VARY
The accounting rules must be incorporated by U.S. public companies for fiscal year 2019, with implementation by private firms following by fiscal year-end 2020. While effects of the standards can be discussed in broad strokes, the operations and objectives of each company will need to be evaluated in order to select and implement the preferred accounting treatment. Ultimately, accounting standards will need to be added to the list of factors occupiers weigh when making leasing decisions. With so many interwoven considerations, an educated leasing professional is advantageous to achieving the optimal solution.